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PORTFOLIO PERSPECTIVES | ARTICLE – 3 Min

The illiquidity premium in private asset markets

By RAUL LEOTE DE CARVALHO 04.08.2023

In this article:

    Investing in private assets can lead to higher returns when compared to public markets, at least over the longer term. In this last of our three-part overview* on private asset investing drawn from our recent paper, we look at how private asset outperformance – the illiquidity premium – can be seen as compensating investors for their willingness to lock up capital for five to 15 years, the usual lifecycle of private equity and private debt investments.  

    Private equity firms, in particular those involved in buyouts, appear to have had persistently higher returns than the US S&P 500 equity index over the past 30 years, net of fees. One recent study shows that US private equity buyouts, including management fees, outperformed the S&P 500 by 2.3% to 3.4% a year between 1986 and 2017.

    This outperformance appears to persist even when the public equity indices are adjusted to better reflect the nature of the companies targeted by private equity, for example, by using small capitalisation benchmarks.

    The study covering the 1986-2017 period showed that US private equity buyouts outperformed the Russell 2000 index, comprising 2,000 small-cap US companies, by 2.3% to 4.3% a year. This is even more remarkable when considering that the Russell 2000 does not include management fees.

    Leverage, small-cap and value exposures  

    Despite such results, the question of whether typically higher leverage private equity outperforms public equity remains hotly debated. Yet the same study cited above shows that when comparing the performance of US buyouts to a leveraged Russell 2000 at 1.2 times, the excess returns remain positive.

    In assessing the performance of private equity versus public equity returns, numerous studies use Public Market Equivalent (PME) as a metric. One study based on PME finds that all US buyout vintages between 1994 and 2014 outperformed the S&P 500. The results were similar when using the Russell 2000 index. For global private equity, another study reached a similar conclusion: buyout pooled returns outperformed the MSCI World index on a PME basis in 19 out of the 20 measured vintage years (1999–2018).

    Should private equity buyout benchmarks include a tilt towards value stocks because buyout targets tend to trade at lower valuation multiples than the market? Research shows that US buyout funds have historically outperformed public market indices even after adjustments for leverage (beta), and small-cap and value exposures.

    Paying an illiquidity premium

    When high-quality capital is scarce, private equity firms typically pay an illiquidity premium to investors less sensitive to liquidity shocks, that is, targeting investors who can provide long-term capital and have a higher tolerance to illiquidity, thereby potentially realising higher returns.

    While the academic literature on private debt is scarcer, it too tends to show evidence of an illiquidity premium relative to other forms of debt.

    One study looked at the performance of private debt funds by collecting timed cash flow data on 448 funds listed in Preqin with vintage years from 1986 to 2018. The average of those vintages of private debt funds realised a 9.2% internal rate of return net of fees for investors between 1996 and 2020.

    The study compared the performance of the private debt funds with those of public investment-grade (IG) and high-yield (HY) bond benchmark indices using the public market equivalent method. Here, private debt outperformed the IG and HY benchmarks by 8% and 6%, respectively, over the period of retention of the fund, i.e., about 0.9% and 0.7% a year, respectively, assuming an average life of nine years for each vintage.

    It seems clear that private assets tend to outperform public assets, often with lower risk. This is supported by various studies and research papers, and our own analysis of benchmarking performance data. This outperformance can be seen as an illiquidity risk premium – basically compensation to investors for the risk of holding illiquid assets over prolonged periods.

    For more on investing in private assets, visit our private assets page

    *Also in this series: An introduction to private asset investing and Private asset allocations in open-ended funds

    Disclaimer

    Private assets are investment opportunities that are unavailable through public markets such as stock exchanges. They enable investors to directly profit from long-term investment themes and can provide access to specialist sectors or industries, such as infrastructure, real estate, private equity and other alternatives that are difficult to access through traditional means. Private assets do, however, require careful consideration, as they tend to have high minimum investment levels and may be complex and illiquid.
    Please note that articles may contain technical language. For this reason, they may not be suitable for readers without professional investment experience. Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients. This document does not constitute investment advice. The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay. Past performance is no guarantee for future returns. Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher-than-average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity or due to greater sensitivity to changes in market conditions (social, political and economic conditions). Some emerging markets offer less security than the majority of international developed markets. For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk.
    Environmental, social and governance (ESG) investment risk: The lack of common or harmonised definitions and labels integrating ESG and sustainability criteria at EU level may result in different approaches by managers when setting ESG objectives. This also means that it may be difficult to compare strategies integrating ESG and sustainability criteria to the extent that the selection and weightings applied to select investments may be based on metrics that may share the same name but have different underlying meanings. In evaluating a security based on the ESG and sustainability criteria, the Investment Manager may also use data sources provided by external ESG research providers. Given the evolving nature of ESG, these data sources may for the time being be incomplete, inaccurate or unavailable. Applying responsible business conduct standards in the investment process may lead to the exclusion of securities of certain issuers. Consequently, (the Sub-Fund's) performance may at times be better or worse than the performance of relatable funds that do not apply such standards.

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